Why Domain Knowledge Is Critical For A VC

Yesterday I answered a question on Quora concerning VC attention
in the wake of endless meetings. My post Many ideas + few vcs = :-( was my response.

However, a participant in the discussion wrote a comment that was
cynical about the venture selection process, partly due to lack
of domain knowledge and partly due to the impact of “social
proof.” The example for lack of depth of knowledge and in thought
was the following:

If I went to a VC and showed
them a technology that used key-value stores and novel caching
mechanisms to speed up SPARQL queries on large RDF
data sets by 10,000x, and then showed them a graph of the
revenue growth of comparable semantic web
infrastructure companies; what would the VC take away from
that? If you are lucky, he will remember “they make something
go faster,” and “other companies in this market are growing at
30 percent a year.”

My answer is below.

You raise an interesting point about the value of domain
specificity (versus the generalist approach) to venture
investing. You have a healthy cynicism and I’m sure it’s
well-founded based upon your experience. In my fund, for
instance, we are laser-focused on big data tools, technologies
and applications. If you came to us with an idea that involved
the technical depth you jokingly referred to above, it would be
screened by my colleague Brad, who has his Ph.D in EE, signal
processing and machine learning, worked at Lockheed and
Microsoft, and was Craig Mundie’s technical adviser for six
years. Would he be able to assess the potential impact of your
idea? He would certainly understand the approach; whether he
made the go/no go decision you would like is another matter
entirely, but his domain expertise would render understanding a
non-issue. This is one of the reasons why I think domain
knowledge in venture investing is really important.

However, it is also incumbent upon the entrepreneur to choose
the right VCs to target and to leverage their networks to get
the warm introduction you mentioned above. And make no mistake,
I agree with you that the warm introduction likely improves a
VC's receptivity to a pitch by 100 times. But if an
entrepreneur can’t figure out a way to get to me or one of my
colleagues then they’re not trying very hard, and these people
don’t possess the kind of persistence and determination I am
looking for in an entrepreneur. You might think this is stupid;
I don’t. It’s simply reality. This is very different, however,
then the “follow the herd” mentality of social proof to which I
believe you are referring. I’ve routinely done deals that many
have thought were less attractive because I’ve believed in the
entrepreneurs an the idea. This is also something you should be
validating when you approach a potential investor. Have they
led stuff? Do they have the courage of their convictions?

As to your final point, we listen to lots of pitches from
companies, most of which we won’t invest in, because it’s our
job: it’s fun; it’s stimulating; and it makes us better at
picking the right companies and helping those companies to our
fullest ability. True dat.

The commenter goes on to discuss the seeming randomness of the
venture investment process and the apparent meaninglessness of
meetings:

VCs are not domain experts.
They are not qualified to critique the content of
your pitch and evaluate the economic potential of your
technology or business model. Even the top tier
and exceptionally experienced VCs are often surprised
at the success or failure of their portfolio companies;
companies they believed were sure bets are often lackluster and
near write-offs -- like Cisco -- turned out to be a
goldmine.

When making an investment decision, a VC
must integrate information from a very large number
of very fuzzy factors, each of which has little predictive
validity. Hopefully in aggregate these factors will result in a
better-than-random investment decision.

Overall, I think pitches and communications outside of the
boardroom are used as a screening mechanism, as a formalized
way for a venture capitalist to evaluate you and your company
against his internal factor model.

The material content of your pitch is almost irrelevant. I
have no idea what most venture capitalists would gain
from attentively listening to pitches instead of playing with
their Blackberries.

There are some bold statements
in this comment. VCs are not domain experts? Really? Hmmm…There
are those who are not, though I know many who are. Whether a VC
is a domain expert or not has little bearing on whether or not
one is surprised by outcomes: EVERY venture investor has
surprises on the upside and the downside, and myriad factors well
beyond domain knowledge impact the success or failure of a
business. HOWEVER, I’d argue that domain expertise helps mitigate
randomness, but is not in and of itself the determining factor in
venture outcomes. But it is certainly an important piece of the
puzzle in my experience. Finally, I’d agree that pitch materials
are of limited value, but are far from irrelevant. They help the
investor understand the entrepreneur’s passion, vision and
current thought process. I have worked with founders on
establishing plans that are markedly different from those they
came in with, because they had the domain knowledge and fertile
mind to recognize a potentially better approach to addressing a
market need. Other times the pitch was pretty much the business
that got built, and with great success. Like everything in the
venture business, and as noted in the comment above, venture
investors go through an implicit factor analysis of which the
pitch is a part. But on a stand-alone basis it is of limited
value.

Bottom line, I’ve found that domain expertise has added a lot to
our portfolio companies and has played a role in de-risking seed
stage investments. I believe our entrepreneurs would agree.
Perhaps there are those whose generalist knowledge is so vast and
powerful that they can overcome gaps in domain expertise, and
that they are comfortable subbing out this part of the due
diligence process, but I don’t roll that way.